Is There a Better Alternative to Central Clearing of Swaps?

OneChicago Exchange offers an established exchange-traded product that could replace some types of swaps — without having to create an entirely new market infrastructure.

Maybe there's a better way. Exchanges, financial institutions and clearing organizations are spending an awful lot of time and resources to centrally clear swaps transactions. But is there an alternative to swaps trading that doesn't require new technology investments?

David Downey, CEO of OneChicago, says there already are financial instruments traded on exchanges that act much like swaps. It's not surprising that Downey would take this position, since OneChicago bills itself as an equity finance exchange for trading single-stock futures (SSFs) -- a contract between two parties to exchange a specified number of shares in a company on a specified delivery date for a price agreed to today (the futures price or strike price).

SSFs, according to Downey, provide increased transparency by moving some types of swaps trades to exchanges from the opaque bilateral market where many transactions take place today. For instance, SSFs can be used instead of stock lending or margin lending -- major business lines for brokerages, he says.

EASING THE PAIN OF SWAPS REFORMDodd-Frank's unintended consequences are proving painful, particularly in the $600 trillion derivatives market. WS&T's March digital issue examines the biggest challenges to central clearing of OTC derivatives and offers a road map to ease the pain of swaps reform.

The SSFs traded on the OneChicago exchange, Downey explains, are accessed through securities brokers, which all investors already have. And since all brokers already are connected to multiple venues, including OneChicago's parents CME and the CBOE, the connectivity already is in place, he insists. "All that interested parties have to do is open up a port on their platform and they are connected to OneChicago," Downey tells Wall Street & Technology.

Brokers, however, see SSFs and OneChicago as a direct threat to their existing (and lucrative) stock and margin lending businesses, according to Andy Nybo, principal and head of derivative research at Tabb Group. "The expense of building a stock lending franchise is substantial," he says. "And the banks enjoy large margins in stock lending. Banks would see an impact by moving to an exchange-traded product," such as SSFs.

In the Spirit of Transparency

"OneChicago is providing another way to gain exposure to long/short equities, and it is doing it in the spirit of Dodd-Frank," Nybo says. "But how willing investors are to look for new investment products, that remains to be seen."

He adds, "To be successful, OneChicago needs to get the interest of market makers and larger market participants in the space. ... They will require deep markets. As always, liquidity begets liquidity."

Currently, OneChicago lists 16 securities brokers or futures account merchants that are connected to the exchange, including ICAP, Interactive Brokers (which also is an investor), Newedge, optionsXpress and UBS Securities. The limited number of brokers, according to the firm's Downey, points to the fact that SSFs are a direct and threatening competitor to the established margin and securities lending markets. Brokers, he contends, would rather continue to steer their clients to their own securities lending businesses, which generate handsome revenues.

There also are nine vendors that provide front-end trading screens connected to OneChicago's matching engine, which is powered by CBOEdirect technology. CBOEdirect supports a FIX API as well as a proprietary API, known as CMi. According to OneChicago's website, many brokerages also have built proprietary applications that interface with the firm's match engine.

Downey reports that the exchange's volume in SSF contracts is growing, although it is still small compared with other asset classes. In January, the exchange saw 301,804 securities futures contracts traded, up 82 percent from January 2010. Of the overall volume, 100,505 were SSFs, with the remainder comprising Exchange Future for Physicals (EFPs) and blocks.

Although volume is growing, OneChicago needs to attract institutions to make its presence felt, Tabb Group's Nybo stresses. "If they can build interest and trading activity from the target market, it could have a measurable impact," he says. "The key to future growth is certainly getting institutional volume."